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The City watchdog tonight said that banks deemed "too big to fail" could be broken up to protect the financial system from future crises.
A paper by the Financial Services Authority (FSA) recommends that systemically important banks should produce "living wills" to set out how problems would be resolved.
FSA chairman Lord Turner said this could lead to banks splitting retail operations from riskier investment banking business "with the latter able to fail even if the former were supported in crisis conditions".
He also attacked the return of mega bonuses to the City where payments for 2009 are set to hit £6 billion.
"The priority use of high investment bank profits must be to enhance capital levels rather than to support excessive bonus payments," said Turner.
The proposals for banking reform came as the rift between the Government and the Bank of England - which together with the FSA make up the tripartite system of regulation - intensified.
Gordon Brown and Alistair Darling rebuked Bank Governor Mervyn King yesterday after he said the biggest banks must be cut down to size.
Deputy Governor Paul Tucker today said the Bank was trying to stimulate international debate that tackles "whether banks are too big, or as Mervyn King said, too important to fail".
Turner recommended banks should hold more capital to protect against potential losses. He said that in some cases living wills would lead to certain banks being broken up.
"The direction of travel is clear: the overall level of capital required in the banking system must be significantly increased over time, while liquidity standards must be significantly tightened," said Turner.
"These changes are required to create a more stable financial system for the long term: the challenge now is to determine the precise, long-term objective and the appropriate transition path.
"Meanwhile, the FSA has to reduce the danger that authorities in future will be faced with only one option - using public funds to rescue whole groups with only equity holders suffering loss.
"And we must also limit the extent to which implicit government guarantees support unnecessary levels of risky proprietary trading.
"The way to achieve this is likely to be a number of mutually reinforcing policies, not a single silver bullet."
Reader views (4)
The lunatics have taken over the asylum! The Regulators screw up but then propose the solutions to the problem they presided over? Why are L Turner et al still in their jobs? Surely the whole incompetent bunch should have been sacked so that at least the latest drivel from the FSA has a modicum of credibility?
- James Macleod Ritchie, Oyster Bay Cove
The sooner, the better. It was a grave mistake to turn the mutuals into banks. Can or will, that grave error ever be reversed? And put the Governor of the Bank of England in full charge of the money and the situation that existed before Gordon Brown waved his tragic wand and reverse his mad decisions. Perhaps Dave will do it?
- Albert Hall, hove england
Why were so many banks allowed to merge - creating superbanks - in the first place, and where were the BOE and the other EU regulators when this was happening? The fact that none of these so called experts even had an inkling that anything could possibly go wrong shows not only extremely bad judgement but also a total lack of ability to do the job that they are paid to do. The buck stops with them.
- Linda, London
The solution is to remove limited liability from risk takers once they realise they are not just playing with other peoples money it suddenly becomes a different game.
- Andy Davids, London
